The Macroeconomic and Budgetary Effects of an Illustrative Policy for Reducing the Federal Budget Deficit

Summary

As requested by Senators Kent Conrad and Jeff Sessions, Chairman and Ranking Member of the Senate Budget Committee

The federal government's debt has increased dramatically in the past few years, and large annual budget deficits will probably continue indefinitely under current laws or policies. If current laws remain unchanged, deficits will total roughly $7 trillion over the next 10 years, the Congressional Budget Office (CBO) projects; if certain policies that are scheduled to expire under current law were extended instead, deficits would be much larger. Beyond the coming decade, the aging of the U.S. population and rising health care costs will put increasing pressure on the federal budget. If debt held by the public continues to expand faster than the economy—as it has since 2007—the growth of people's incomes will slow, the share of federal spending devoted to paying interest on the debt will rise more quickly, and the risk of a fiscal crisis will increase. At the same time, the recovery from the recent recession has been anemic, and the economy remains in a severe slump. CBO and many private forecasters expect that the unemployment rate will remain high, and that output will remain well below the economy's potential, for a number of years.

This analysis describes the economic and budgetary effects of an illustrative policy that would reduce primary deficits—that is, total budget deficits excluding net interest payments—by a cumulative $2.0 trillion between 2012 and 2021 relative to CBO's baseline projections, before taking into account any economic effects of the policy. The reduction in primary deficits under that policy, excluding economic effects, was assumed to equal $100 billion in 2012 and to increase gradually until it reaches $300 billion in 2021. That illustrative policy does not incorporate any assumptions about the particular mix of spending or revenue changes and is not meant to correspond to any specific legislative proposal. Such a reduction in future deficits would result in lower federal debt than is currently projected, thus reducing the government's interest costs. Taking into account those savings in interest, CBO estimates that the illustrative policy would lower deficits by a total of $2.4 trillion over the 2012–2021 period, under an assumption that those budgetary changes would have no effect on the economy.

But, in fact, budgetary changes would affect the economy—in differing ways in the short term and over the medium term and long term:

In the short term, while the economy is relatively weak and economic growth is restrained primarily by a shortfall in demand for goods and services, the reduction in federal spending or increases in taxes that would produce smaller deficits would decrease the demand for goods and services even further and thus reduce economic output and income. In addition, long-term interest rates would be lower than if the deficit reduction did not occur.

Over the medium term and long term, when economic output is determined by the supply of labor and capital and the productivity of those inputs, the reduction in federal borrowing that would result from smaller deficits would induce greater national saving and investment and thereby increase output and income. Long-term interest rates would continue to be lower than if the deficit reduction did not occur.

CBO used two approaches to estimate the effects of the illustrative policy on the economy. Those approaches focus on somewhat different aspects of the economy: One approach is used to estimate short-term effects only; the other addresses medium-term and long-term effects. Because considerable uncertainty surrounds many of the economic relationships that are fundamental to this analysis, CBO used a range of assumptions about the short-term effects on output of changes in federal spending and taxes and about the effects on national saving and investment of changes in deficits—and reports results corresponding to smaller, medium-sized, and larger effects on output. Even so, the macroeconomic impact of a reduction in primary budget deficits of $2.0 trillion could lie outside the range of estimates reported here, depending on the specific policies chosen, the future state of the economy, and numerous other factors. The magnitude of the impact of future deficit reduction on interest rates is especially uncertain.

CBO estimated the effects of the illustrative policy relative to the current-law assumptions underlying CBO's baseline projections. According to those estimates, lower demand resulting from the illustrative policy would decrease real (inflation-adjusted) gross national product (GNP) in 2012, 2013, and 2014 by amounts ranging from roughly 0.1 percent to 0.6 percent depending on the year and the assumptions used. In addition, long-term interest rates would be reduced by about 0.1 to 0.4 percentage points during those years. Beyond 2014, the estimates show that the illustrative policy would lead to gains in GNP that increased over time. Near the end of the decade, in the years from 2019 through 2021, real GNP would increase by roughly 0.5 percent to 1.4 percent, again depending on the year and the assumptions used. Long-term interest rates would be reduced by about 0.1 to 0.2 percentage points.

The changes in the economy would in turn affect the federal budget—through changes in such factors as taxable income (which affects the amount of revenues collected) and interest rates (which affect the government’s borrowing costs). Specifically, CBO's analysis indicates the following:

The macroeconomic effects of the illustrative policy would increase primary deficits by small amounts in the first part of the coming decade and reduce them by small amounts in the latter part of the decade. Because the gains in GNP generated by the policy would increase further beyond the decade, the reduction in primary deficits would continue to grow as well.

The macroeconomic effects would reduce federal interest payments—over and above the reduction attributable to the lower levels of debt that would result from the policy—because the policy would lead to lower interest rates (relative to those underlying CBO's baseline projections) in every year. Those savings would be much larger than the net savings arising from the changes in primary deficits induced by the macroeconomic effects of the policy, and would also continue to grow beyond the end of the decade.

Under the set of assumptions that imply medium-sized effects of the illustrative policy on output, the macroeconomic effects of the policy would reduce deficits by about $185 billion, over and above the $2.4 trillion reduction in primary deficits and interest costs estimated before accounting for the macroeconomic effects. Therefore, the illustrative $2.0 trillion reduction in primary deficits (relative to CBO's baseline projections) would yield a total reduction in deficits of about $2.6 trillion from 2012 through 2021.

Alternative scenarios for deficit reduction would generate different macroeconomic effects and resulting budgetary effects. For example, a policy that had a different amount of cumulative reduction in primary deficits but that reduced deficits on the same gradual time path as the policy analyzed here would have macroeconomic and budgetary effects that differed by roughly the same percentage as did the cumulative amount of deficit reduction. Thus, for example, a reduction in primary deficits that followed the same gradual time path but was twice as large would produce macroeconomic effects that were roughly twice as large as those shown here.

A different policy that had the same amount of cumulative reduction in primary deficits but that reduced deficits more slowly than the policy analyzed here would have more favorable macroeconomic effects in the next few years but less favorable ones later in the decade. The total budgetary impact of slower deficit reduction would be smaller, for two reasons. First, the policy's impact on interest rates would be smaller. Second, because the reduction in debt would occur more slowly, the resulting savings in interest costs would have less time to compound.

A related question concerns the effects of the same illustrative $2.0 trillion reduction in primary deficits on the same timetable analyzed here, but assuming that those reductions were relative to a scenario other than the circumstances under current law. In that case, the macroeconomic and resulting budgetary effects of the policy would probably be similar, but not identical, to the effects described here. For example, compared with an alternative fiscal scenario that led to significantly greater amounts of debt than in CBO's baseline, the illustrative policy would reduce interest rates slightly more than presented here, and the larger amount of debt under the alternative fiscal scenario would imply that a given reduction in interest rates would lead to a larger reduction in interest payments. As a result, relative to such a scenario, the budgetary implications of the macroeconomic effects of this illustrative policy would be modestly larger.